Central bankers on the future of central banking, part 1

On June 24-25 2010, the Bank for International Settlements (BIS) held its 9th Annual Conference in Lucerne, with the theme being “The future of central banking”. Why this theme? As Stephen Cecchetti, Economic Advisor and Head of Monetary and Economic Department, BIS, noted in his introductory remarks to the conference, no central banker can be unaware that the global crash of 2008 happened on their watch:

“… we have just been through an event of a magnitude on the Goodhart seismic scale that is beyond once-in-a-lifetime. The near collapse of the financial system happened not only in our back yards, but in our front yards too. Whether or not central banks were responsible for all of the terrain that was ravaged, we nonetheless claim expertise in financial systems, institutions and markets and their connection to all things monetary. And the crisis struck on our watch. It would seem discordant to suggest that there is little need for us to consider a change in approach […] we need to understand the long-term implications of the events we are living through. That is a towering challenge.”

Cecchetti draws a parallel with the central bankers who presided over the inter-war years and had to grapple with the hugely destabilizing effects of the war debts stemming from World War 1. As he notes, this era has been marvellously portrayed by Liaquat Ahamed in his book: “Lords of Finance: The Bankers who Broke the World”. Out of that instability came the hyperinflation of the Weimar Republic and the rise of the Nazis in Germany. Because the central bankers at the time did not understand the nature of the monetary crisis (the “tectonic forces”) set in motion by the scale of the war debts, they floundered about in a sea of confusion. Cecchettie suggests that the parallel is an uncomfortable one:

“We are again seeing signs that the international adjustment mechanism intrinsic to the current monetary regime is being put under strain by cross-country payment imbalances. And again we are seeing signs of crippling debt burdens…”

What really worries Cecchetti is not so much the way some central bank balance sheets have become bloated with assets as a result of stimulus initiatives, but rather the trajectory of public debt. I have already commented on an earlier paper on the growth of public debt, authored in part by Cecchetti, so it is particularly telling to find him taking the opportunity of kicking off the BIS conference by drawing the attention of all the delegates to what he clearly sees as the problem of the hour:

“As many of you know, in my view and that of the BIS, not enough attention is being devoted to the ominous trajectory of public debt in a number of advanced economies.”

He showed his audience a set of graphs covering the period from 1980 to 2040 for a dozen industrialised countries, including the major Eurozone countries and Japan, the UK and the US. The really scary thing about his graphs are that he plots three lines, one showing the trend as things stand, the second showing what would happen if there is a gradual adjustment downwards (one percentage point a year for five years for all fiscal spending bar age related spending), and the third which demonstrates what improvements could be generated if in addition to the gradual downward adjustment, governments also freeze age related spending at 2011 levels.

Why is this scary? Well, for most countries featured, the third option does wonders for getting to grips with the deficit. Instead of heading for 300% of GDP by 2040 (yikes!) the deficits become a lot more tractable. Greece for example, which on the current trend is heading for about 360% of GDP by 2040 – it would bust of course, long before it got there – finishes up with a deficit of about 80% of GDP. That, of course, is some comfort, given where Greece is now, rather than being terrifying.

Germany does even better, and instead of being around 310% of GDP, its public debt would be about 55% of GDP, not great, but relatively ordinary. The horror stories begin with France, which even on the best scenario, would still be trending upwards gently at around 115% of GDP. The US would be heading for 450% of GDP (a total bust) on the first scenario, but would pull back to somewhere just north of 150% of GDP on scenario 3.

The UK (scary music here please) would be edging towards 500% of GDP by 2040 on the first scenario and will still hit 300% on the best scenario Cecchetti puts forward. Japan is even more of a basket case, going well north of 500% of GDP on scenario 1 and hitting 400% on both scenarios 2 and 3.

To put all this in context, Reinhart and Rogoff show in their brilliant study of eight centuries of past crashes, that when debt levels reach around 90% of GDP, it knocks around 1% off GDP growth, and correspondingly more as the debt mounts. This will stress any economy to the point of disaster. One can see why Cecchetti has begun to bang rather loudly on this particular drum. If this were a 1970s Hammer Horror film, we’d have sirens and flashing red lights about now as the shadow of the great axe falls across the screen.

Those who feel this takes too grim a view of things point to a variety of factors that could play rather better for developed economies like the US, the UK and Japan. Global trade balances could reset themselves over the next few years if Chinese and Indian consumer spending increases strongly, or if China revalues its currency sharply. US manufacturing could really get its act together. The monetization of the debt in the UK and the US could make repayment a lot easier. We could have another really strong decade of growth, and on and on. However, in the light of the last crash, it seems to me that if we allow stern warnings from senior figures in the BIS to go unheeded, bad things are very likely to happen.